In fact: Where Raghuram Rajan may have erred — in policy

Focusing solely on CPI inflation — and ignoring negative WPI inflation — has resulted in producers paying double-digit real interest rates even in a slowdown

Written by Harish Damodaran | Updated: June 22, 2016 11:15 am
reserve bank of india, raghuram rajan, inflation, rexit, rajan rbi, rajan rbi exit, raghuram rajan inflation, rajan rupee policy, rajan rbi policy, rajan rate cuts, rbi monetary policy, consumer price index, wholesale price index, business news, rajan resign news, rexit news, latest news The new framework did not merely fix goals for inflation during any financial year and pin responsibility on the RBI for achieving the same. (Source: Reuters)

Disapproval of Raghuram Rajan’s policies as Reserve Bank of India Governor may not be the most politically correct thing to do today. The person who can be singularly credited with stabilising the rupee during September 2013 — when a fragile Indian economy witnessed speculative capital outflows that brought back memories of 1991 — certainly requires no certificates of nationalism from anybody.

raghuram

But that should still not stop one from taking issue with RBI policies framed during Rajan’s eventful tenure. That includes the monetary policy framework focused on inflation targeting, which was formalised under his guidance through an agreement signed between the RBI and the Finance Ministry.

The new framework did not merely fix goals for inflation during any financial year and pin responsibility on the RBI for achieving the same. These explicit targets were set in terms of the consumer price index (CPI), as opposed to the wholesale price index (WPI).

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The implications of it were not small. In the existing WPI (base year 2004-05), food items have a total weight of 24.31 per cent, while being as high as 45.86 per cent in the case of the 2012-base combined (rural + urban) CPI.

Now, we know that raising interest rates can do very little to bring down prices of onions, potatoes or pulses. Monetary policy tools are effective in controlling inflation that is mainly demand-led. For example, making home loans expensive can help cool overheated property markets. But food inflation has more to do with supply-side pressures. In this case, it is rising prices — not higher interest rates — that actually help reestablish equilibrium between demand and supply, by suppressing the former and stimulating the latter.

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While CPI inflation in India traditionally always ruled higher than WPI inflation, the differences weren’t significant enough to impact conduct of monetary policy. The RBI’s key short-term lending or repo rate of 8 per cent in May 2014 — when the current government came to power — was higher than the WPI inflation of 6.2 per cent and a tad below CPI inflation of 8.3 per cent. With the base rate charged by banks at 10-10.25 per cent, producer-borrowers effectively paid 4 per cent interest in real terms. The repo rate, then, ranged roughly between WPI inflation and the minimum lending rate of banks.

But the divergence between CPI and WPI inflation started widening significantly from around August 2014, as the accompanying chart (left) shows. By November, WPI inflation had entered negative territory and remained there for the next sixteen months. The monetary policy framework agreement, which committed to meeting inflation targets anchored to the CPI, was entered into in February 2015. At that time, the gap between CPI inflation and WPI inflation had already crossed 7.5 percentage points, and widened further to 8.8-9 percentage points by August-September.

This led to an unprecedented situation. On the one hand, producers were experiencing deflation, with the prices of their products falling year on year. But on the other, since the repo rate was being set with reference to CPI inflation — the WPI had practically ceased to exist for the RBI — and this was being brought down only gradually, producers were effectively now borrowing at double digits in real terms.

In August-September 2015, State Bank of India’s base lending rate was 9.7 per cent. Taking the WPI inflation of minus 5 per cent, it translated into a real interest rate of almost 15 per cent! Primary producers not using imported inputs — whose costs may have fallen because of the global commodity collapse — would have suffered all the more as a result.

The above situation was brought about solely by the RBI’s adoption of the CPI as the “nominal anchor” for inflation-targeting. True, the CPI inflation was also falling, but only slowly thanks to sticky food prices — on which the RBI, ironically, had no control. In recent months, we have seen CPI inflation going up again — and as before, the villains are the same old tomatoes, potatoes and tur or urad dal.

Defenders of Rajan’s monetary policy suggest that too much is made of interest rates. Investment and demand for credit is hardly influenced by these, they say, while noting that banks in 2007-08 were lending at 12-13 per cent and the repo rate itself was 9 per cent (as against 7.5 per cent now).

Well, the argument misses a simple point: For borrowers, what matters is not nominal but real interest rates. Through 2007 and 2008, WPI inflation averaged around 6.5 per cent, which means they were paying an interest of 5.5-6.5 per cent in real terms. But today, if the prices of what they are producing are barely increasing and nominal interest rates are still above 10 per cent, it means double-digit real interest rates. That surely isn’t conducive for investment or credit offtake.

Critics of the RBI’s policy of targeting CPI inflation are not entirely wrong in claiming that it has inflicted collateral damage to the Indian economy, by keeping interest rates too high for too long. The very fact that the success in meeting CPI inflation targets is predicated on what happens to food prices also, in turn, creates an anti-farmer policy bias. It naturally predisposes policymakers towards freezing minimum support prices, imposing curbs on farm exports and stocking limits at the slightest indication of prices going up, and opening up to duty-free imports.

We have seen these in ample measure in the last two years.

 

harish.damodaran@expressindia.com

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    Parikshit
    Jun 20, 2016 at 10:43 pm
    Mr Damodaran's entire argument rests on one simple umtion- that the entire divergence between the CPI and WPI is due to food perishables inflation. Now nowhere has he provided data to support this umption. His entire premise rests on one single line mentioned as a fact: that food items carry a weightage of 25 pc in WPI but 45 pc in CPI. Other than that he has dispensed with the need to prove that WPI targeting would result in a better rate regime. I would like to suggest to Mr Damodaran that he must provide two statistics to support his arguments: comparative WPI and CPI timelines with their major consuent weightages , and historical ociation of WPI and CPI curves with monetary policy changes. Without these basic statistics it is difficult to accept the conclusion drawn in this article. The data presented is woefully inadequate, and the entire conclusion seems presumtive/speculative in nature.
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      Amartya
      Jun 21, 2016 at 5:54 pm
      The author appears to have forgotten two key things (either deliberately or due to lack of background research): (a) the WPI is NOT a producer price index (PPI): a government panel is currently working on creating a PPI for India; and (b) the WPI doesn't include the service sector, which is 60% of output and 40 percent of employment. This is indeed why the WPI is not a PPI. A little bit of background research may be useful before writing "provocative" pieces.
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        ashok s
        Jun 20, 2016 at 11:00 pm
        Prima facie you have written a nice article, but was it that the reason where rajan erred, ya may be the one amongst many. I personally feel there is huge liquidity crunch in system. Our cad and fiscal deficit are still persistent. What ever reserves we have are thru stocks, bonds, and FDI . which are redeemable or repatriated any time. So one has to think twice before touching it. Now the scenario ,what must have happened is that government wanted RBI to print extra bills so that government can get the liquidity by issuing bonds to RBI . and same liquidity could have been infused into system thru banks, or other instruments. But then difference must have arosed between the governor and government. It is said that anyway finmin is way ahead superior then RBI chief.
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          Ashish kumar
          Jun 21, 2016 at 5:45 pm
          Rajan is a Trojan Horse. His policies are favour big industry inasmuch by suffocating smse he weakens compeion. This is why all the industry leaders and their mouth-pieces (the selective Indian and foreign press which owns the means and wherewithal to be more vocal) are supporting him. On the other hand, major chunk of employment is generated by the smse. Discouraging these hurts common man and poor people. How much do these western educated intellectuals who are entrenched in the West and cater to their interests, care for the poor Indian mes?
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            Ashish kumar
            Jun 21, 2016 at 5:46 pm
            Rajan is a Trojan Horse. His policies favour big industry inasmuch as by suffocating smse he has weakened compeion to them. This is why all the industry leaders and their mouth-pieces (the selective Indian and foreign press which owns the means and wherewithal to be more vocal) are supporting Rajan. On the other hand, major chunk of employment is generated by the smse. Discouraging these hurts common man and poor people. How much do these western educated intellectuals who are entrenched in the West and cater to their interests, care for the poor Indian mes?
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              ANUPAM
              May 7, 2017 at 1:02 am
              Mr Raghuram Rajan Is The Best Economist we have got but due to swami he didnot extension otherwise he would take India to greater heights.
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